The True Cost of Withdrawing Early From Your 401(k)
You have this wonderful resource called a 401(k) that is helping you save for retirement. Maybe your employer is even throwing in some funds to make it grow even more. But then something crazy happens and you need cash and you need it now. Are you tempted to tap into this retirement piggy bank to take care of other expenses?
Don’t do it! Here’s why:
You’ll Get Dinged
Just like money doesn’t grow on trees, some things are just too good to be true. Digging into your 401(k) for anything but retirement is definitely too good to be true, no matter how enticing that big pile of money is to you. The good old IRS will get you in two ways:
Believe it or not, the government doesn’t want you to spend that hard-earned retirement money before retirement. That’s why they will slap you with a 10% fee if you withdraw it before you reach the age of 59.5. Sure, they’ll gladly take your money if you decide to go this route, but the penalty is meant to discourage you from digging into these funds early.
Desperate times = desperate measures, which is why in 2011, the IRS collected 5.7 billion dollars in early withdrawal penalties. 1 That’s a ten-digit figure made up of millions of Americans eating away at precious retirement savings.
Want to know the scary part? Workers aged 20–29 cash out their 401(k)s the most — 44% of them, in fact! 2 These are the prime savings years, so you’re really shooting yourself in the foot if you do this. But this 44% (and all the other age brackets too) aren’t just sacrificing 10%, they’re forfeiting another chunk in taxes and compound interest.
A major perk of contributing to a 401(k) is that you are saving on taxes at the beginning. You only pay the taxes when you withdrawal the money (which may be 30+ years down the road). If you withdrawal the money early, not only will you get taxed on your income earned from working, but you will be taxed on the amount you take out of your 401(k), which could even push you into a higher tax bracket. This would be a true double tax whammy.
No one wants to pay more taxes, but if you cash out even a portion of your 401(k), you are willingly and unnecessarily handing money over to Uncle Sam.
Compound interest is just a fancy way of saying all the earnings on your principal and the interest that keeps building. The growth of compound interest is counter-intuitive, but it’s a very powerful concept. A good visual is a cartoon snowball growing bigger as it rolls down a hill (it starts out small, but soon after it gets bigger at a faster rate). If you take any part of your 401(k) out, you are losing potential growth. This is the critical point most people lose sight of when they only look at their short-term financial situation.
Your money is earning money for itself by just sitting there. Without compound interest, it would be incredibly difficult, even impossible for most of us, to earn enough to sustain us in the future. It is the growth of our investment that really makes the difference, and it’s a powerful difference!
Want to see how all three factors can affect your future retirement?
The Nitty Gritty Numbers
Cashing out a 401(k) may seem harmless, but once you look at the numbers you can see how much it’ll hurt your pocketbook in the future.
Let’s say Michael, who is 30 years old, withdraws $15,000 from his 401(k) to pay off student loans. Since he earns $50,000 a year, he is taxed 25%. On top of that, he lives in Michigan and faces a 4.25% state tax. Okay, here’s how his withdrawal pans out:
-25% federal tax ($3,750)
-10% early withdrawal penalty ($1,500)
-4.25% Michigan tax ($637.50)
=$9,112.50 total distribution!!
That’s a substantial loss. Not only do you sacrifice almost $6,000 at the front end, but you also forfeit the compound interest on the $15,000 in the long-term. You essentially lose out twice.
How much of a difference will compound interest make, you ask? Look at these figures:
Using all the same numbers above and assuming an 8% annual rate of return on his investments, Michael stands to lose almost $95,000 in future funds from that $15,000 withdrawn now.
Use this calculator to see how this would look for you.
Real Life Cautionary Tale
I have a friend that started a business a few years ago. The initial arc of entrepreneurship typically goes like this: it will take twice as long and cost twice as much (or more) to get your little idea off the ground. This was the case for my friend. He quickly burned through his initial “seed money” stash.
There was a shortage of cash, but no shortage of optimism.
Soon my friend’s 401k — built up to a sizable amount from years in the corporate world — was too much to resist. He tapped it for more seed money and justified his actions by telling himself that he will easily “pay it back” when business is booming. This made me cringe. Unfortunately the business never took off, and my friend was stuck with heaps of taxes and penalties the following year.
An Alternative Option
If you are truly desperate for cash, a better option is take out a loan on your 401(k). You won’t face the extra tax or IRS penalty, but you will need to pay back the loan within five years (or earlier if you leave your employer before then).
The pros and cons of this alternative are simple.
Pros: you pay back principal and interest to yourself and there are often low interest rates for this type of loan.
Cons: You are taxed twice — on the interest paid with after-tax money and again when the money is withdrawn in retirement. The biggest con is that you are cheating yourself out of that coveted compound interest. While you are paying back the loan, that big chunk you took out is not growing.
Here’s the takeaway: withdrawing from your 401(k) should be a last resort. I’m talking creditors after you, eviction notice type of last resort. Before you see your 401(k) as a bonus piggy bank, research other options. You want your money to be waiting for you when you retire, trust me on this one. If you have 10 minutes, schedule a brief “Office Hours” session with me to discuss your biggest 401(k) or other financial concern. There’s no obligation or catch. I’ll give you my thoughts and recommendations so that you can maximize your 401(k) to build wealth smarter.
Could Your 401(k) Be Working Harder?
For many people, a 401k is their largest retirement account. It deserves your undivided attention. Download our Ultimate 401(k) Guide for a step-by-step strategy to master your 401(k), including a prioritized checklist. It’s free!
Pathway founder and principal Greg Brown is a fee only financial advisor with broad financial planning and investing expertise. Greg’s financial advice has been featured in publications like Yahoo Finance, Bankrate, Investopedia (all articles here), Wall Street Journal, and USA Today. He holds a master’s degree from the University of Chicago and a mechanical engineering degree from Michigan State University. Prior to Pathway, Greg was a lead analyst at Morningstar and previously held engineering roles at Dell (including a US Patent).
Originally published at Independent Financial Advisor | Pathway.